EmergDoc's Investing Plan Thread [White Coat Investor]
Posted: Mon Feb 28, 2011 6:48 pm
When I find myself repeating the same advice over and over I like to put a comprehensive post together that I can link to later to save myself the typing. Examples include past threads on the savings rate, military investing, how to get rich etc.
This one is my response to the frequent poster who posts a question such as “I have $50K saved up and I need to know which funds to put it in!”
My response is: You need an investing plan. I don’t care if you write it down into a formal Investing Policy Statement (see the wiki http://www.bogleheads.org/wiki/Investme ... _Statement), although I think that’s a useful step, but at a bare minimum you need it in your head. Here’s how you make an investing plan. Once you have that, you’ll never have to wonder “What funds should I put this money in?”
How do you make an investing plan?
Step 1 is to formulate your goals. Be as specific as possible, realizing that you’ll make changes as the years go by. Examples of good goals include:
I want $40,000 for home downpayment by June 30, 2013.
I want to have enough money to pay the tuition at my alma mater in 13 years when my 5 year old turns 18.
I want to have $2 Million saved for retirement by Jan 1 2030.
Any goal is better than no goal, but the more specific and the more accurate you can be, the better.
Step 2 is to set up a plan for each goal. The plan consists of identifying what type of account you will use to save the money, choosing the amount you will put toward the goal each year, working out an asset allocation likely to reach the goal with the minimum risk necessary, and identifying a plan B for the goal in case the returns you’re planning on don’t materialize. Let’s look at each of the goals identified in turn and make a plan to reach them.
First, the goal to save up a downpayment.
2A-Choose the type of account. In this case, the best option is a taxable account since it will be relatively short term savings and you don’t want to pay a penalty to take the money out to spend it. A Roth IRA may also be a good option for a house downpayment.
2B- Choose how much to save. When you get to this step it is a good idea to get familiar with the FV formula in excel. FV stands for future value. There are basically 4 inputs to the formula-how much you have now, how many years until you need the money, how much you will save each year, and rate of return. Playing around with these values for a few minutes is an instructive exercise. Also, knowing what reasonable rates of return are can help. If you put in a rate of return that is far too high (such as 15%) you’ll end up undersaving. Since you need this money in just 2 ½ years you’re not going to want to take much risk, so you might only want to bank on a relatively low rate of return and plan to make up the difference by saving more. You decide to save $1400 a month for 28 months to reach your goal. According to excel, this will require a 1.8% return.
2C- Determine an asset allocation. This is likely the hardest stage of the process. Reading some Bogleheadish books such as Ferri’s All About Asset Allocation or Bernstein’s 4 Pillars of Investing can be very helpful in doing this. In this case, you need a relatively low rate of return. The first question is can I get this return with a guaranteed instrument…i.e. take no risk at all. Usually you should look at CDs, money market funds, bank accounts etc to answer this question. MMFs are paying 0.1%, bank accounts up to 1.2% or so, 2 year CDs up to 1.5%, so the answer is that in general, no, you can’t. One exception at this particularly unique time is a high-interest checking account. By agreeing to do a certain number of debits a month, you can get a rate up to 3-4% on up to $25K. So that may work for a large portion of the money. In fact, you could just open two accounts and get your needed return with no risk at all. A more traditional solution would require you to estimate expected returns. Something like 0% real (after-inflation) for cash, 1-3% real for bonds, and 3-6% real for stocks is reasonable. Mix and match to get your needed return.
2D- Lastly, you need a plan in case you don’t get the returns you are counting on, a “Plan B” of sorts. In this case, your plan B may be to either buy a less expensive house, borrow more money, make offers that require the seller to pay more of your closing costs, or wait longer to buy.
Let’s repeat the exercise for the second goal, saving for college.
Goal- 4 years tuition at the Alma Mater beginning in 13 years. Let’s say current tuition is $10K a year. You estimate it to increase at 5%/year. So 13 years from now, tuition should be $19,000 a year, or $76K. Note that you can either do this in nominal (before-inflation) figures or in real (after-inflation) figures, but you have to be consistent throughout the equation.
Vehicle: You wisely select your state’s excellent low cost 529 plan which also gives you a nice tax break on your state taxes.
Savings amount: Using the FV function again, you note that a 7% return for 13 years will require a savings of $4000 per year.
Asset Allocation: You expect 3% inflation, 5% real so 8% total out of stocks and 2% real, 5% total out of bonds. You figure a mix of 67% stocks and 33% bonds is likely to reach your goal. Since your Plan B for this goal is quite flexible (have junior get loans, pay for part out of then current earnings, or go to a cheaper school,) you figure you can take on a little more risk and you go with a 70/30 portfolio.
Plan B: Have junior get loans or choose a cheaper college.
Let’s attack the third goal, admittedly more complicated. You figure you’ll need your portfolio to provide $80K a year (in today's dollars) for you to have the retirement of your dreams. Using the 4% withdrawal rule of thumb, you figure this means you need to have portfolio of about $2 Million (in today's dollars) on the day you retire, which you are planning for January 1st 2030 (remember it is important to be specific, not necessarily right about stuff like this-you can adjust as you go along.) You have $200K saved so far. So using the FV function, you see that you have a couple of different options to reach that goal in 19 years. You can either earn an 5% REAL return and save $49,000 a year (in today's dollars), or you can earn a 3% REAL return and save $66,000 a year (again, in today's dollars). Remember there are only three variables you can change-return, amount saved per year, and years until retirement. Fix any two of them and it will dictate what the third will need to be to reach the goal.
Goal-$2 Million portfolio on Jan 1 2030
Vehicle: Roth IRAs, 401K, taxable account
Savings amount: $49000/year
Asset Allocation: After much reading and reflection on your own risk tolerance and need, willingness, and ability to take risk, you settle on a relatively simple asset allocation that you think is likely to produce a long-term 5% real return:
35% US Stock Market
20% International Stock Market
20% Small Stocks
25% US Bonds
Plan B: Work longer or if prevented from doing so, spend less in retirement
You have now completed step 2, setting up a plan for each goal. Step 3 is relatively simple at this point.
Step 3 is to select the best (usually lowest cost) investments to fulfill your desired asset allocation. Using all or mostly index funds further simplifies the process. Let’s take the retirement portfolio. You have $200K in Roth IRAs and plan to put $5K a year into your IRA and your spouse’s IRA each year through the back-door Roth option. You also plan to put $16.5K into your 401K each year. Unless your spouse also has a 401K, you're going to need to use a taxable account as well to save $49K a year. Your 401K has a reasonably inexpensive S&P 500 index fund which you will use as your main holding for the US stock market. It also has a decent PIMCO actively managed bond fund you can use for your bonds. You’ll use the Roth IRAs for the international and small stocks. So in year one, the portfolio might look like this:
His Roth IRA 40%
25% Total Stock Market Index Fund
20% Total International Stock Market Index Fund
Her Roth IRA 45%
20% Vanguard Small Cap Index Fund
25% Vanguard Total Bond Market Fund
His 401K 5%
5% S&P 500 Index Fund
His Taxable account 5%
5% Vanguard Total Stock Market Index Fund
As the years go by, the 401K and the taxable account will make up larger and larger portions of the portfolio, necessitating a few minor changes every few years.
After this, all you need to do to maintain the plan is monitor your return and savings amount each year, rebalance the portfolio back to your desired asset allocation (which may change gradually as you get closer to the goal and decide to take less risk), and stay the course through the inevitable bear markets and scary economic times you will undoubtedly pass through.
Let’s do one more example, just to help things sink in. Joe is of more modest means than the guy in the last example. He works a blue-collar job and can really only save about $10K a year. He would like to retire as soon as possible, but he admits it was hard to watch his 90% stock portfolio dip and dive in the last bear market, so he isn’t really keen on taking that much risk again. In fact, if he had to do it all over again, he’d prefer a 50/50 portfolio. He figures he could get 5% real out of his stocks, and 2% real out of his bonds, so he expects a 3.5% real return out of his 50/50 portfolio. He expects social security to make up a decent chunk of his retirement income, so he figures he only needs his portfolio to provide about $30K a year. He wants to know how long until he can retire. He has a $100K portfolio now thanks to some savings and a small inheritance.
Goal: A portfolio that provides $30K in today’s dollars. $30K/.04=$750K
Type of account: He has no 401K, so he plans to use a Roth IRA and a SEP-IRA since he is self-employed.
Savings amount: He is limited to $10K a year by his wife’s insistence that the kids eat every day.
Asset allocation: He likes to keep it simple, so he’s going to do:
30% US Stocks
20% Intl Stocks
25% TIPS
25% Nominal bonds
He expects 3.5% real out of this portfolio. Accordingly, he expects he can retire in about 29 years. =FV(3.5%,29,-10000,-100000)=$760,295
Plan B: His wife will go back to work after the kids graduate if they don’t seem to be on track
Investments:
Year 1
Roth IRA 30%
VG TIPS Fund 25%
TBM 5%
Taxable account 65%
TSM 30%
TISM 20%
TBM 20% (he’s in a low tax bracket)
SEP-IRA 5%
VG TIPS Fund 5%
So now we get back to the hypothetical OP’s question. “I have $50K that I need to invest. Where should I put it?” The first consideration is why haven’t you invested it yet? You should be investing the money as you make it according to your plan. If it is a windfall, and you’ve already maxed out your Roth IRAs and 401Ks for the year, you can either use it toward your retirement goal, investing it in a different type of account (such as a taxable account) but still toward your asset allocation for that goal, or you can put it toward a different goal such college savings, paying down the mortgage etc. Alternatively, you could spend it or even give it away to charity.
A few last words about developing an investment plan:
If you fail to plan, you plan to fail.
Any plan is better than no plan.
The enemy of a good plan is the dream of a perfect plan.
There are no old, bold [investors].
Good luck investing.
Edited to incorporate several useful suggestions mentioned lower in the thread
This one is my response to the frequent poster who posts a question such as “I have $50K saved up and I need to know which funds to put it in!”
My response is: You need an investing plan. I don’t care if you write it down into a formal Investing Policy Statement (see the wiki http://www.bogleheads.org/wiki/Investme ... _Statement), although I think that’s a useful step, but at a bare minimum you need it in your head. Here’s how you make an investing plan. Once you have that, you’ll never have to wonder “What funds should I put this money in?”
How do you make an investing plan?
Step 1 is to formulate your goals. Be as specific as possible, realizing that you’ll make changes as the years go by. Examples of good goals include:
I want $40,000 for home downpayment by June 30, 2013.
I want to have enough money to pay the tuition at my alma mater in 13 years when my 5 year old turns 18.
I want to have $2 Million saved for retirement by Jan 1 2030.
Any goal is better than no goal, but the more specific and the more accurate you can be, the better.
Step 2 is to set up a plan for each goal. The plan consists of identifying what type of account you will use to save the money, choosing the amount you will put toward the goal each year, working out an asset allocation likely to reach the goal with the minimum risk necessary, and identifying a plan B for the goal in case the returns you’re planning on don’t materialize. Let’s look at each of the goals identified in turn and make a plan to reach them.
First, the goal to save up a downpayment.
2A-Choose the type of account. In this case, the best option is a taxable account since it will be relatively short term savings and you don’t want to pay a penalty to take the money out to spend it. A Roth IRA may also be a good option for a house downpayment.
2B- Choose how much to save. When you get to this step it is a good idea to get familiar with the FV formula in excel. FV stands for future value. There are basically 4 inputs to the formula-how much you have now, how many years until you need the money, how much you will save each year, and rate of return. Playing around with these values for a few minutes is an instructive exercise. Also, knowing what reasonable rates of return are can help. If you put in a rate of return that is far too high (such as 15%) you’ll end up undersaving. Since you need this money in just 2 ½ years you’re not going to want to take much risk, so you might only want to bank on a relatively low rate of return and plan to make up the difference by saving more. You decide to save $1400 a month for 28 months to reach your goal. According to excel, this will require a 1.8% return.
2C- Determine an asset allocation. This is likely the hardest stage of the process. Reading some Bogleheadish books such as Ferri’s All About Asset Allocation or Bernstein’s 4 Pillars of Investing can be very helpful in doing this. In this case, you need a relatively low rate of return. The first question is can I get this return with a guaranteed instrument…i.e. take no risk at all. Usually you should look at CDs, money market funds, bank accounts etc to answer this question. MMFs are paying 0.1%, bank accounts up to 1.2% or so, 2 year CDs up to 1.5%, so the answer is that in general, no, you can’t. One exception at this particularly unique time is a high-interest checking account. By agreeing to do a certain number of debits a month, you can get a rate up to 3-4% on up to $25K. So that may work for a large portion of the money. In fact, you could just open two accounts and get your needed return with no risk at all. A more traditional solution would require you to estimate expected returns. Something like 0% real (after-inflation) for cash, 1-3% real for bonds, and 3-6% real for stocks is reasonable. Mix and match to get your needed return.
2D- Lastly, you need a plan in case you don’t get the returns you are counting on, a “Plan B” of sorts. In this case, your plan B may be to either buy a less expensive house, borrow more money, make offers that require the seller to pay more of your closing costs, or wait longer to buy.
Let’s repeat the exercise for the second goal, saving for college.
Goal- 4 years tuition at the Alma Mater beginning in 13 years. Let’s say current tuition is $10K a year. You estimate it to increase at 5%/year. So 13 years from now, tuition should be $19,000 a year, or $76K. Note that you can either do this in nominal (before-inflation) figures or in real (after-inflation) figures, but you have to be consistent throughout the equation.
Vehicle: You wisely select your state’s excellent low cost 529 plan which also gives you a nice tax break on your state taxes.
Savings amount: Using the FV function again, you note that a 7% return for 13 years will require a savings of $4000 per year.
Asset Allocation: You expect 3% inflation, 5% real so 8% total out of stocks and 2% real, 5% total out of bonds. You figure a mix of 67% stocks and 33% bonds is likely to reach your goal. Since your Plan B for this goal is quite flexible (have junior get loans, pay for part out of then current earnings, or go to a cheaper school,) you figure you can take on a little more risk and you go with a 70/30 portfolio.
Plan B: Have junior get loans or choose a cheaper college.
Let’s attack the third goal, admittedly more complicated. You figure you’ll need your portfolio to provide $80K a year (in today's dollars) for you to have the retirement of your dreams. Using the 4% withdrawal rule of thumb, you figure this means you need to have portfolio of about $2 Million (in today's dollars) on the day you retire, which you are planning for January 1st 2030 (remember it is important to be specific, not necessarily right about stuff like this-you can adjust as you go along.) You have $200K saved so far. So using the FV function, you see that you have a couple of different options to reach that goal in 19 years. You can either earn an 5% REAL return and save $49,000 a year (in today's dollars), or you can earn a 3% REAL return and save $66,000 a year (again, in today's dollars). Remember there are only three variables you can change-return, amount saved per year, and years until retirement. Fix any two of them and it will dictate what the third will need to be to reach the goal.
Goal-$2 Million portfolio on Jan 1 2030
Vehicle: Roth IRAs, 401K, taxable account
Savings amount: $49000/year
Asset Allocation: After much reading and reflection on your own risk tolerance and need, willingness, and ability to take risk, you settle on a relatively simple asset allocation that you think is likely to produce a long-term 5% real return:
35% US Stock Market
20% International Stock Market
20% Small Stocks
25% US Bonds
Plan B: Work longer or if prevented from doing so, spend less in retirement
You have now completed step 2, setting up a plan for each goal. Step 3 is relatively simple at this point.
Step 3 is to select the best (usually lowest cost) investments to fulfill your desired asset allocation. Using all or mostly index funds further simplifies the process. Let’s take the retirement portfolio. You have $200K in Roth IRAs and plan to put $5K a year into your IRA and your spouse’s IRA each year through the back-door Roth option. You also plan to put $16.5K into your 401K each year. Unless your spouse also has a 401K, you're going to need to use a taxable account as well to save $49K a year. Your 401K has a reasonably inexpensive S&P 500 index fund which you will use as your main holding for the US stock market. It also has a decent PIMCO actively managed bond fund you can use for your bonds. You’ll use the Roth IRAs for the international and small stocks. So in year one, the portfolio might look like this:
His Roth IRA 40%
25% Total Stock Market Index Fund
20% Total International Stock Market Index Fund
Her Roth IRA 45%
20% Vanguard Small Cap Index Fund
25% Vanguard Total Bond Market Fund
His 401K 5%
5% S&P 500 Index Fund
His Taxable account 5%
5% Vanguard Total Stock Market Index Fund
As the years go by, the 401K and the taxable account will make up larger and larger portions of the portfolio, necessitating a few minor changes every few years.
After this, all you need to do to maintain the plan is monitor your return and savings amount each year, rebalance the portfolio back to your desired asset allocation (which may change gradually as you get closer to the goal and decide to take less risk), and stay the course through the inevitable bear markets and scary economic times you will undoubtedly pass through.
Let’s do one more example, just to help things sink in. Joe is of more modest means than the guy in the last example. He works a blue-collar job and can really only save about $10K a year. He would like to retire as soon as possible, but he admits it was hard to watch his 90% stock portfolio dip and dive in the last bear market, so he isn’t really keen on taking that much risk again. In fact, if he had to do it all over again, he’d prefer a 50/50 portfolio. He figures he could get 5% real out of his stocks, and 2% real out of his bonds, so he expects a 3.5% real return out of his 50/50 portfolio. He expects social security to make up a decent chunk of his retirement income, so he figures he only needs his portfolio to provide about $30K a year. He wants to know how long until he can retire. He has a $100K portfolio now thanks to some savings and a small inheritance.
Goal: A portfolio that provides $30K in today’s dollars. $30K/.04=$750K
Type of account: He has no 401K, so he plans to use a Roth IRA and a SEP-IRA since he is self-employed.
Savings amount: He is limited to $10K a year by his wife’s insistence that the kids eat every day.
Asset allocation: He likes to keep it simple, so he’s going to do:
30% US Stocks
20% Intl Stocks
25% TIPS
25% Nominal bonds
He expects 3.5% real out of this portfolio. Accordingly, he expects he can retire in about 29 years. =FV(3.5%,29,-10000,-100000)=$760,295
Plan B: His wife will go back to work after the kids graduate if they don’t seem to be on track
Investments:
Year 1
Roth IRA 30%
VG TIPS Fund 25%
TBM 5%
Taxable account 65%
TSM 30%
TISM 20%
TBM 20% (he’s in a low tax bracket)
SEP-IRA 5%
VG TIPS Fund 5%
So now we get back to the hypothetical OP’s question. “I have $50K that I need to invest. Where should I put it?” The first consideration is why haven’t you invested it yet? You should be investing the money as you make it according to your plan. If it is a windfall, and you’ve already maxed out your Roth IRAs and 401Ks for the year, you can either use it toward your retirement goal, investing it in a different type of account (such as a taxable account) but still toward your asset allocation for that goal, or you can put it toward a different goal such college savings, paying down the mortgage etc. Alternatively, you could spend it or even give it away to charity.
A few last words about developing an investment plan:
If you fail to plan, you plan to fail.
Any plan is better than no plan.
The enemy of a good plan is the dream of a perfect plan.
There are no old, bold [investors].
Good luck investing.
Edited to incorporate several useful suggestions mentioned lower in the thread
Setting a $80,000 nominal income retirement goal may, if inflation is high for the 19 years between now and retirement, produce the retirement of your nightmares. 
Keeping in mind that median household income in the US is less than $50,000. This is a classic example of giving retirement planning advice that makes most people give up on planning for retirement. :lol: 